starbucks4ever (98.33)

I think I found an undervalued ticker after all

7

I found one stock that is relatively cheap, and that is a pseudo-stock. My today's choice is TIP. It gives you exposure to government TIPs with the average maturity of about 9 years. Unlike other expensive junk, it hasn't rallied at all this year. But the reason to own it is very compelling. Stock market is telling us that it expects huge inflation, otherwise stock valuations don't make sense. But the TIPs market disagrees, suggesting inflation on the order of 3%.

At the current price, TIP offers a good margin of safety. Unless you expect inflation to be under 3%, the price shouldn't go much lower. If inflation hits 4-5%, then TIP should perform very well. And also, if TIP fails to perform, then S&P should have a pullback because inflation is priced in. Enjoying a small but still positive return while everybody else has his equity portfolio going down? One can certainly do much worse than that.

Risks:

At the current moment, I don't see a large risk of default. Even though the government is behaving like a typical Ponzi borrower, it still has at least a decade during which it can increase deficits without anyone noticing. But if deficits keep growing too fast, it could become a concern. A second major risk is a change in accounting methods that would understate CPI by more than the current 0.7-0.8% per year. Any news to that effect should be a reason to sell. Having said that, I still like TIP at $104 much better than I like S&P at 1200.

Actually stock prices forecast low inflation. The reason is that when you do a DCF, earnings in future years get moved back to the present by discounting them at your hurdle rate. If you have a very high hurdle rate (like you would in a high inflation environment) then money out more than a few years isn't worth much. We currently have high PE ratios. If the market were forecasting high inflation, we would have low PE ratios.

(Note, this is not an argument that current valuations make any sense, just that forecast inflation isn't the reason for them being this high.)

I invest some of my 401k in TIPS. My biggest issue with them is that the rate of inflation is based on the CPI. I look at the Clinton era CPI formula at www.shadowstats.com and it is double what the current formula shows. It seems to me that TIPS will benefit from higher interest rates and inflation, but not by as much as it should. I agree that the risk of default is low. The return is also low.

It's true that the discount rate would increase if high inflation were anticipated, but revenues and earnings would also increase, which would offset that to a large degree.

zloj,

I don't know much about US treasuries to be honest, but I'm assuming one pays somewhat of a premium for TIPS protection and my belief is that inflation stays rather low. Hence, I'd rather buy regular treasuries right now. That said, there's no chance in hell that I would buy treasuries with such ridiculously low yields.

I know they are understating inflation (then again, who doesn't know this?), but this is why I said the market expects 3% inflation. Formally, TIPS yields indicate 2% inflation, so I added 1% to take into account the well-known tricks from the statistical bureau.

#4

I like 4% yield for a 10-year note much better than 2% yield. So treasuries are still too expensive, but maybe not as expensive as they were last year. But still, even with a good rate, I would feel very uneasy about committing to fixed nominal yield. It's much better, IMHO, to own a TIPS than a bond, and know that it would hold some value even if we go Zimbabwe, whereas a 6% bond would then become totally worthless.

I like DBA at 24.65 better than TIP at 104 (and either way better than SPY). Funds already dove headfirst into stocks, oil, gold, silver, platinum, palladium, copper, etc, etc. Rises of 40-100+ percent in roughly a year... DBA hasn't blinked...maybe it never will, but it's the safest place for awhile, offering relatively minimal downside and equal or greater upside than TIP.